Wednesday, December 28, 2016

I enjoyed this short video of Scott Sumner and Larry White discussing fiat currency versus the gold standard. Check it out here.

Sumner's key argument is that a properly managed fiat currency can out perform a gold standard. Sumner is optimistic that central banks are learning to do a better job. White responds that central banks have not done better than a gold standard. Further, he argues that the very existence of central banks causes problems because they will seek to tinker with the monetary system causing more harm than good.

I think Sumner pointed out the key problem with a gold standard, and that is its decent performance requires appropriate monetary policy by foreigners. White argues in favor of free banking. Suppose that his argument wins the day in the U.S., but China adopts the gold standard while rejecting free banking. Now the world economy is held hostage to the Chinese central bank's foolish notions. (Or, the world economy might be improved by wise policy by the Chinese central bank.)

I don't really agree with White's emphasis on central bank mischief. A government has no need for a central bank to implement a monetary policy under a gold standard. The Treasury can sell newly issued government bonds for gold and create an economic contraction. Or, it can sell off gold and pay down its national debt and create an expansion. The contraction has an interest cost--it must pay more interest on outstanding government bonds than otherwise. And the inflation has an upward limit--the government's gold reserve.

Of course, there is also the traditional government power of devaluation and revaluation. Interestingly, central banks have not had that power delegated to them. I suppose White just would like to forbid that power to government. My own view is that devaluation would be the least bad response if some foreign central bank pulled a France--accumulating gold reserves.

Consider how President-elect Trump would respond if a gold standard China were to devalue its currency and build up as a gold reserve the resulting gold inflow? Tariffs? Or is this an act of war?
With a free banking system, the resulting U.S. recession (depression) would almost certainly result in the exercise of the option clause. The interest penalty for the banks would motivate a measured deflation. I think the answer is for the government to devalue so that there is no deflation and instead try to guess on a new price of gold so that nominal GDP would continue to stay on its trend growth path.

Irving Fisher long ago explained how regular devaluations and revaluations of gold would provide price level stability in the context of a gold standard. Of course, the compensated dollar is hardly a gold standard at all. It would seem that gold can be dispensed with (though the emphasis of central bankers on interest rates and the odd bicycle nature of interest rate targeting suggest that the compensated dollar might have its uses.)

And it is that sort of thinking that makes the concept of "fiat currency" defended by Sumner problematic. It creates the habit of mind where paper currency plays the role of gold. With free banking, paper money is instead a debt instrument. Removing gold and using another nominal anchor doesn't change that. Even under current institutions, paper money is better understood as a kind of government debt. In my view, the key problem with gold as a nominal anchor is that it serves as a tolerably good money itself. And changes in the demand for it, from anywhere in the world, results in tremendous economic disruption.

That is why I prefer free banking to be tied to some other nominal anchor. Slow and steady growth in nominal GDP looks to be the least bad option to me.

Wednesday, December 21, 2016

I think that Trump's election has greatly improved the prospects for real economic growth by reducing the prospect of stringent controls on greenhouse gases. I think it likely that the resulting increase in the production of greenhouse gases will add to global warming, so this is the "global warming boom."

The alarmist rhetoric that mainstream Democrats have adopted regarding global warming would suggest the necessity of highly restrictive regulation of the production of carbon dioxide. Cold-turkey pollution control is (or should be) a textbook example of a supply-side recession. If there really were a prospect of planet Earth turning into Venus, a Great Depression scale contraction of real output and real income would be possible and justified.

Of course, few elected officials would support such a policy Much more likely would be a gradual tightening of regulations so that real output grows more slowly. Over time, the growth path of real output and real income would be substantially lowered, but at least in terms of design, there would be no periods where regulation would cause it to actually drop. There would be no supply-side recession, but just simply slower growth. Given the very slow increase in per-capita real income at best, the result could easily be stagnation in material standards of living.

If the pollution in question were noxious gases emitted into the atmosphere or poisons disposed into rivers, lakes, or oceans, the benefits of a cleaner environment would be plain. It is possible that the sacrifice of material goods and services would be worth it--even a rapid Great-Depression scale contraction of real output. It seems likely to me that a supply-side recession would be efficient at least in parts of China. That measures like GDP fail to fully capture changes in human welfare should not be a major concern. This is just one of many circumstances where the rough rule of thumb that higher and more rapid growth in per capita real GDP improves human welfare fails.

That reduced emission of greenhouse gases into the atmosphere provides a less immediate and obvious benefit does not necessarily mean that it does not increase human welfare on net, but the sacrifice of material goods and services still remains as a cost. How much benefit from less future climate change will appear in the present?

For all of the apocalyptic rhetoric, there hasn't really been all that much regulation as of yet. And so, the current economic impact was about expectations of future regulations and somewhat less global warming. The surprise election of Trump has now caused any increased regulation to recede into the more distant future while the global warming is more likely to be slightly worse.

Anticipated regulations that will reduce real income from what otherwise would be will tend to increase saving. Current consumption is reduced to cushion the blow to future consumption due to lower future incomes. However, expectations of global warming should also increase saving. Consumption is reduced now so that future consumption is protected perhaps from the impact of lower income but also from the need to use future resources to mitigate against problems caused by climate change. While this implies an ambiguous result for saving, the more immediate and certain cost of the future regulation versus the more distant and speculative effect of global warming suggests more saving now on net.

The impact on investment is more important. The likely introduction of strict regulation of carbon dioxide in the near future would immediately depress investment in durable capital equipment that generates substantial carbon dioxide. This would be especially true for efficient regulations that penalize existing capital goods, such as a carbon tax. Command and control regulation that applies solely to new investment would not have such an effect. Quite the contrary, there should be a rush to invest before the regulation is applied. Cap and trade could have a similar effect if the caps reward those firms that currently emit the most carbon dioxide.

While the prospect of regulation of carbon would make investment in capital equipment that emits relatively little carbon dioxide more profitable, there seems little reason to purchase any of it until just before the new regulations will begin to bite. It would seem that the most sensible strategy would be to refrain from new investment, including regular replacement of existing equipment, accumulate short term financial assets, and then purchase "environmentally-friendly" capital equipment right before the new regulations are implemented.

What kind of investment would be encouraged by some decrease in the intensity of global warming in the future? More building in coastal areas? Agricultural buildings? Planting fruit trees?

It seems to me that the most likely effect of the prospect of intense regulation of greenhouse gases would be an increase in the saving supply and decrease in investment demand. This results in a lower natural interest rate.

This would be somewhat temporary. After the regulations are implemented, the supply of saving would decrease in an effort to maintain consumption.

The demand for investment is ambiguous. The opportunity to replace capital goods that generate substantial regulatory costs with new capital goods that emit less carbon dioxide and other greenhouse gases would increase investment demand. However, these techniques would have already been more profitable if they were more effective in producing output. This suggests that the reduction in investment demand must be at least partially permanent.

Still, there is good reason to believe that the natural interest rate would temporarily decrease before the regulations are implemented and then at least partially recover after carbon emissions are more strictly regulated. If the prospect for regulation recedes, then the result should be a decrease in saving supply and increase in investment demand and so a higher natural interest rate.

The impact of an increase in saving supply and decrease in investment demand on the allocation of resources between the production of consumer and capital goods depends on which changes more and the interest elasticity of saving supply and investment demand. At first pass, there is no effect at all--while both changes reduce the natural interest rates, they have opposite impacts on the allocation of resources. While I would usually think the interest elasticity of investment demand is much greater than for saving supply/consumption demand, in this situation I would anticipate that the effort to save for the future would fail and firms would still postpone investment in capital equipment. In other words, assuming the interest rate coordinates properly, the result would be increased production of consumer goods and services and fewer carbon-dioxide emitting capital goods.

More troubling is the possibility that the market rate fails to match the decrease in the natural interest rate so that at least part of the reduced investment demand and increased saving supply simply results in idle resources. Further, the fear of these costly regulations, by deterring investment now one way or another, will begin to adversely impact growth of labor productivity.

Removing the threat of these regulations, then, would have the opposite effects. The increase in investment demand will quite plausibly generate a substantial increase in investment and the addition to the capital stock will enhance labor productivity.

That the Fed prefers to target short and safe interest rates has resulted in almost a decade of poor policy because short and safe interest rates are so low. If firms begin to spend off their large holdings of short and safe securities and instead purchase capital goods, this problem will be greatly relieved. The "Taylor rule" should begin to work somewhat better.

Finally, if we had the sort of massive contraction of real output that appears justified by the alarmist rhetoric of the Obama administration, the consequences for employment would very much depend on the monetary regime. The direct and immediate effect of these stringent regulations would be to make the production of goods and services more difficult. The reduction in supplies would tend to increase the prices of products. A policy of strict inflation targeting would require that this be offset by reduced demand. Equilibrium would require a substantial decrease in nominal and real wages. It is difficult to see how anyone could pay off existing debts in such an environment, and so widespread bankruptcy and financial reorganization would be necessary. In other words, inflation targeting implies that a supply-side recession has an impact qualitatively similar to a demand side recession.

With nominal GPD targeting, the decreases in the supplies of various goods and services that require the emission of carbon would result in increases in their prices and so a transitionally higher inflation rate. Real wages and real debts would be decreased. With such a wrenching change in real production conditions, there would be substantial structural unemployment and business failures. However, the collateral damage due to unnecessary bankruptcies and unrealistically high real wages would be greatly mitigated.

The implication of inflation targeting in the more realistic scenario where the regulations are implemented gradually so as to solely limit growth would have similar effects, but much less severe. Spending growth must slow to prevent the slower growth in productivity/supplies from creating inflation and nominal and real wages must grow more slowly as well. Stagnation in real wages is a real possibility given how slowly they grow anyway.

When it is simply a matter of the prospect of more stringent regulations in the future, there is no immediate tendency for supply to be depressed other than the gradual impact of reduced investment on the capital stock and labor productivity. If the market rate has failed to fall with the natural interest rate, inflation might well remain low. Even so, nominal wages would need to grow more slowly in order for employment to be maintained.

Nominal GDP targeting would allow result in in modestly higher inflation when real output growth is slowed due to the gradual tightening of regulation. Since nominal wage growth appears to have substantial momentum, the higher inflation will slow the growth of real wages and so tend to reduce any unnecessary reductions in employment. The inflation will also modestly reduce real interest rates, and so help avoid the scenario where the market rate fails to decrease with the natural interest.

And if the threat of these regulations recedes into the distant future? The need for a lower real market interest rate and slower growth in nominal and real wages disappears.

The global warming boom--more investment, more productivity, more rapid growth in real and nominal wages, and more employment. And a somewhat greater threat of harm from global warming.

Tuesday, December 20, 2016

President-elect Trump and other critics of NAFTA seem especially concerned about U.S. firms moving manufacturing operations from the U.S. to Mexico and then exporting their products to the U.S. U.S. domestic production is decreased and U.S. imports are increased.

The concern is especially described as a transfer of jobs from the U.S. to Mexico. U.S. workers lose their jobs and Mexican workers obtain jobs. One of the common economic fallacies in the notion that "jobs" are a limited resource and this appears to redistribute some of the scarce jobs from Americans to foreigners.

Of course, it is labor that is scarce rather than "jobs." Shifting production of some good from the U.S. to Mexico is only efficient if there is a comparative advantage in Mexico relative to the U.S. That means that the opportunity cost in Mexico is lower than the opportunity cost in the U.S.

Perhaps it is a matter of too much abstraction in my thinking, but the process by which Mexican production of some good partially or fully displaces U.S. production of that good would involve entry by Mexican entrepreneurs with lower production costs who then drive the higher cost U.S. producers out of business. Having the U.S. producers promptly shut down and open a new facility in Mexico would seem to be a more efficient means of accomplishing the same end.

The logic of comparative advantage is that the expansion of Mexican production comes at the expense of other Mexican industries with relatively higher opportunity costs. Labor and other resources are pulled away from the production of products where Mexico does not have the comparative advantage.

Further, the contraction of this U.S. industry frees up labor and other resources to produce products with relatively lower opportunity costs. Resources are pushed into the industries where the U.S. has the comparative advantage.

However, the "moving jobs" to Mexico scenario combines this with a shift of capital resources from the U.S. to Mexico. Imagine the factory is loaded onto a giant truck and hauled across the border. Capital would literally move from the U.S. to Mexico.

The shift of capital resources away from the U.S. would typically reduce the demand for complementary factors in the U.S., in particular U.S. labor. While this would tend to lower wages and labor income, the reduction in the supply of capital in the U.S. would tend to result in a higher rate of return on capital in the U.S. When combined with the earnings on foreign investment, total income would rise. The result would tend to be lower U.S. GDP but higher U.S. GNP.

This process of factor income equalization is not tied to the trade flows that depend on comparative advantage. Suppose there were no trade in goods and services between Mexico and the U.S. They could still put the factory on a truck and shift it over the border and sell their product in Mexico. The remaining U.S. producers would earn more profit and there would still be lower U.S. wages.

The primary effect of combining the two processes--shifting U.S. capital to Mexico while importing products from Mexico is that U.S. consumers and workers benefit from lower import prices while seeing some increase in imputed labor demand from export industries. GDP is decreased by the shift of capital resources but increased due to the reallocation of resources according to comparative advantage. The effect on domestic production and labor income is ambiguous while the effect on capital income, when including the return on foreign investment, is positive.

Now, in reality, the U.S. has a net capital inflow. While the shift of factories from the U.S. to Mexico is a capital outflow, it is more than offset by other shifts of capital to the U.S. We know this from observing the U.S. trade deficit which is matched by a net capital inflow. Real interest rates in the U.S. are at historically low levels, suggesting that U.S. labor incomes are not suffering due to a process of international factor price equalization.

The process of factor price equalization--the transfer of capital resources from where the returns are low to where they are high--raises world output and income. It raises income from capital on the whole. But it does tend to reduce labor incomes in those areas that had what in hindsight was an over-abundance of capital.

However, the phenomenon of convergence, by which lower income countries grow rapidly and approach the level of per capita income of high income countries, is not primarily a matter of comparative advantage or capital flows. The key is rather adopting better technology. This should be understood broadly to include new products and production techniques, but also methods of organization and even policies and social norms. This allows what were desperately poor people to produce more, earn more, and consume more. For the most part, they demand the added products they supply.

Thursday, December 8, 2016

Trump has made a variety of statements associated with the Carrier deal. It might be a mistake to take what he says (tweets) too seriously. Still, I find myself thinking about the effects of a policy of imposing tariffs specifically on firms that close a plant in the U.S. and relocate it outside the U.S.

The actual Carrier deal appeared little different from standard state-level economic development programs. State governments have long offered special enticements to large firms considering opening a plant. The different state governments see themselves in competition with other locations--other states and other countries. When firms are considering a move away from a state, this same apparatus frequently kicks in. What can state and local government do to convince a major employer to stay? For the most part, what is unusual with the Carrier deal is that normally the governor of a state and various local elected officials takes credit, but we now have a President grandstanding. The other complication is that Carrier's parent company, United Technologies has federal defense contracts, and some think that Trump threatened future defense contracts.

No, it is not the enticements included in the actual deal that are interesting, but rather Trump's proposal for a special tariff on firms that move outside the U.S. It is not at all clear that this was a threat that worried Carrier or United Technologies.

But what would be the effect of such a policy? I think the presumption should be that such a policy would have no effect. Uneconomic plants located in the U.S. would still be closed. New plants would still open in other countries for the purpose of exporting products to the U.S.

A special tax on the products imported from firms that have "moved" from the U.S. would simply result in an end to talk about moving. A firm opens a new plant in Mexico and then a year or two later, closes the U.S. plant. Open the new plant during the expansion, and close the U.S. plant during the recession. Of course, if the policy is nothing but window-dressing, then just open one plant and close another. Just don't say it is a move.

Sufficiently draconian controls could stop a particular firm from shifting operations across national borders. If a firm closes a plant in the U.S., then tariffs are imposed upon any of its product from other countries that it seeks to export to the U.S.

But in the extreme, the result could simply be that a new firm, or perhaps a subsidiary of a French or German firm, opens in Mexico producing a product such as air conditioners. Profit and depreciation costs from the uneconomic U.S. plant are paid out to the Carrier stockholders, who purchase stock in the firm that operates in Mexico--whatever its name.

It would seem that all the Trump approach can hold hostage is the brand name "Carrier." And I suppose I shouldn't be surprised that Trump puts a lot of stock on brand names. Since they do have value, it should have some impact of delaying the shift of operations from less economic domestic production to more economic foreign production.

Of course, a policy of imposing tariffs on imported air conditioners would have a greater impact than simply punishing U.S. firms that "move" production of air conditioners to Mexico. And all of these policies have approximately no effect on the total employment in the U.S., but rather shift the pattern of employment in the U.S. in a way that reduces total U.S. and foreign income and output.